The Incredible Story Of Fannie & Freddie
I have just made a Macro Watch video about Fannie Mae and Freddie Mac, the two “Government-Sponsored Enterprises” (GSEs) that dominate the US mortgage market. The impact they had on the economy while they were expanding is really pretty mind-boggling and the story of their collapse is quite extraordinary too. In fact, the ongoing economic crisis in the United States cannot be understood without grasping the role they have played in bringing it about. So Fannie and Freddie are the subject of today’s blog.
Congress created Fannie Mae and Freddie Mac decades ago and gave them the mission of promoting access to mortgage credit by increasing the liquidity of mortgage investments. But, as you will see, they did much more than just provide liquidity. They ended up owning the majority of all the home mortgages in the United States. When they failed in 2008, they were taken over by the government. That means the government now owns 60% of US home mortgages. In other words, thanks to Fannie and Freddie, the US mortgage market has largely been nationalized. But let’s start with the boom years.
Between 1987 and 2007, Fannie and Freddie increased their debt by eight times by issuing $7 trillion dollars of bonds. They used the cash they raised to acquire $5 trillion worth of mortgages and $2 trillion worth of other debt instruments. To put that into perspective, in 1987 the entire stock of US home mortgages amounted to only $2 trillion. By 2007, it had increased to $11 trillion. During those two decades, with Fannie and Freddie providing most of the credit, home sales doubled and home prices increased by more than 120%. Rapidly rising property prices allowed Americans to extract equity from their homes and continue spending more every year even though wage growth was severely constrained by globalization and deindustrialization. By 2004, net equity extraction exceeded $700 billion, an amount equivalent to nearly 9% of disposable income. As long as Fannie and Freddie could continue to borrow and buy up mortgages, the boom continued. Americans kept spending and importing, and that allowed the rest of the world to export more and more to the US every year.
In 2008, that all ended when the markets lost faith in Fannie and Freddie’s ability to repay their debts. Once US property prices started to fall, losses in their mortgage portfolio quickly wiped out their thin layer of capital. Both would have collapsed into bankruptcy had the government not intervened by putting them into “conservatorship” in September 2008. To keep them solvent, the Treasury Department injected $187 billion into Fannie and Freddie by acquiring their senior preferred stock. In exchange, the government received 80% of the GSE’s common shares. It now exercises complete control over them and takes all of their profits. At the time of the take-over, the GSEs had considerably more debt outstanding than the government itself ($8.1 trillion vs. $5.1 trillion).
The good news is that Fannie and Freddie have returned to profitability. They have paid the government $219 billion over the last three years. That means the government has made a profit of $32 billion so far. Moreover, the profits should continue. The Obama Administration has projected the two institutions would make payments to the government totaling $181 billion between January 2014 and September 2024.
In another interesting and somewhat outrageous twist, the Fed, as part of its Quantitative Easing program, has acquired $1.8 trillion of the GSE-related debt, or 22% of the total. During the last three years, the Fed has earned $126 billion of interest on those bonds and handed it over to the government, reducing the government’s budget deficit by that amount.
Of course, risks still remain. If the property market crashes again, the government will have to inject more money – potentially much more money – into Fannie and Freddie to keep them afloat. It is also possible that there will be large losses on Fannie and Freddie’s very large derivatives portfolios.
Perhaps most significantly, however, is that Fannie and Freddie have not been allowed to continue increasing their level of debt or the size of their mortgage portfolios since they were put into conservatorship. Consequently, they are no longer causing the economy to grow – as they did for so many years before 2008. Instead, massive budget deficits, Quantitative Easing and ultra-low interest rates have been required to generate economic growth during the years since Fannie and Freddie were reined in. But, the budget deficits are no longer massive and QE has ended. Only ultra-low interest rates are still in place. If the Fed now carries through with its threat to push up interest rates, very bad things are likely to happen to both the economy and US asset prices. The fallout from that would be felt all around the world.
Space does not allow a full explanation here of all of Fannie and Freddie’s shenanigans. To learn more, watch the 30-minute Macro Watch video I uploaded last week.
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